The refinance itch

The Refinance Itch

Think ahead with interest protection

Financial Post June 13, 2009

John and Jennifer Viner bought a home last August for $350,000 with a fixed-rate mortgage at 5.25%. A few months later, interest rates plummeted, hovering at a 50-year low.

The Viners, like many homeowners, started kicking themselves. And now that those low rates are starting to rebound — big banks have already announced hikes in interest rates — the Viners want to take advantage before they disappear completely. They want to refinance at 3.79%, which would save them $19,960 in interest.

The problem is, breaking their contract early comes with an expensive penalty that is made worse by low interest rates: The Viners would pay a penalty of $19,300.

When you do the math, refinancing just doesn’t seem worth the trouble.

There is a way to take advantage of today’s low rate tomorrow, says Julie Cooper, an accredited mortgage professional and associate for The Mortgage Group in Edmonton.

If you think interest rates are going to rise within the next four months — and experts predict they will — you can apply to get pre-approved for a refinance, Ms. Cooper says.

This comes with 120 days of rate protection. Your interest rate is locked in until the time period expires. If rates rise during that time, the homeowner gets to refinance at the lower rate. But the penalty for breaking the contract is calculated using the bank’s current, higher rate. The penalty, known as the Interest Rate Differential (IRD), calculates the difference between your mortgage rate and the current rate set by your bank, multiplied by the remaining months of the term and the outstanding principal.

“Penalty is an emotionally charged word that makes the lenders seem like bad guys for charging it,” Ms. Cooper says. The lender made a deal with the borrower, she explains, promising to lend you money without raising the rate for five years. So, the “penalty” covers the lenders’ shortfall.

The Viners applied for protection at 3.79%. Ms. Cooper heard rumours that rates were rising, so the Viners held tight. Sure enough, two weeks later, their bank’s rates rose to 4.24%. Their penalty shrunk to $14,400, which will net them $5,565 in interest savings.

The couple refinanced for $362,000 (including the penalty) with a 35-year amortization. At the lower rate, their mortgage payments decreased by $180 to $1,552 a month.

If they choose to keep the same mortgage payments and redirect the extra cash flow directly against the principal, they will pay their mortgage off 10.5 years faster.

Bottom line, you are playing the market by refinancing early. Rate protection gives you some leeway to wait for the right moment to pay the smallest penalty for the biggest savings. After all, interest rates have nowhere to go but up.

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